Thomas Fang of UBS explains the basic features, applications, benefits and risks of structured products, including the lessons learnt about them following the experience of the financial crisis.
Date: Mar 2010
Tags: Leverage, Capital protection, Pay offs, Yield, Risks, Suitability
Uses and benefits of structured products
At their simplest, structured products are investment vehicles linked to particular underlyings to serve an investor’s individual needs, said Thomas Fang in an interview.
A structured product can, for example, change the payout profile of an investment.
So if an investor buys a stock directly, the investor gains or loses the same amount as the rise or fall in the stock price. However, a structured product on this stock would enable the investor to get a different type of payout, explained Fang.
For instance, he said, if an investor wants to invest in a stock for a year but without putting principal at risk, it is possible to create a principal protected product to achieve that.
Breaking this down further, it involves the manufacturer putting some of the principal into risk-free assets such as bonds, and then the residual money into a call option linked to the particular stock. This enables the investor to still participate in the upside while protecting the principal, said Fang.
He said it is important to look at the investors’ needs as well as risk profile, so this might involve leverage rather than principal protection.
In terms of other uses for structured products, Fang said some clients might have a specific view on an underlying, so for example might want to buy a stock at a certain price but at the same time get some yield.
It is possible in such cases to design a put option-embedded product to help the client get a certain premium by selling the option but at the same time buying the stock if it trades lower, explained Fang.
Another use of structured products is where a client wants to access a certain asset class or market. This has led to the creation of access, or delta 1, products, said Fang, to provide a certain payout to investors.
Trade-offs
When buying structured products, Fang warned that investors need to look at market risk as well as additional credit risk from the product issuer or manufacturer.
Structured products also have a particular tenor, so there is a liquidity risk given that there is typically only one party – the manufacturer – which can provide liquidity before maturity.
In addition, there are also common investment-related issues for investors to be aware of such as currency risk.
Key lessons from the financial crisis
Following the financial crisis, Fang said manufacturers need to take into consideration two key things.
First is the product suitability, he said, and whether it is appropriate for the type of client or segment into which it is being sold. Issuers need to make sure the products are not too complex for the channels to which they are being marketed.
Secondly is client suitability. In this area, Fang said manufacturers need to rely on the distributors, but added that manufacturers also have a responsibility to provide enough support to distributors in the process.
